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Stock Dividends Sending Buy Signal, But Be Careful

NYSE Trader
Photo: Oliver Quillia for CNBC.com
NYSE Trader

One of the consequences since the Federal Reserve began its monetary easing has been a sharp downturn in long-term interest rates.

It’s worked so effectively, in fact, that the yield on the 10-year Treasury note —used as a benchmark when setting borrowing costs—is now below the yield on the Standard & Poor’s 500.

The index is yielding 2.21 percent, while the 10-year is trading around 1.93 percent.

Under normal circumstances, that move would mark a strong buy signal for stocks.

That’s based on the notion that it makes no sense to tie your money up for 10 years in bonds if the dividend yield alone from stocks is better.

That relationship is not often the case. During the 1980s, for instance, bonds yielded a gaudy 10 percent or better and S&P 500 yields were stuck around 4 percent.

But it has happened on 20 occasions since 1953, and those times have been very good for the stock market, with an average gain of 20 percent.

“Everyone loves a sale, and investors rarely overlook stock market bargains,” Sam Stovall, chief investment strategist at S&P, said in a research note. “So at the end of each quarter when stocks yielded more than bonds, investors have typically gone on a buying spree and have rarely been disappointed.”

In the 20 cases where stocks yielded more than bonds, stocks rose 80 percent of the time. The most recent example was at the March 2009 post-financial crisis market low, when the S&P posted a robust 60 percent gain in the following 12 months.

There are a couple dangers, though, in betting on the yield difference this time around.

The most apparent is that the Fed has been manipulating yields through its quantitative easing efforts. The central bank meets this week and is expected to launch another intervention, this time by selling short-dated securities and buying longer-dated debt in what is known as Operation Twist.

Should it follow through on that plan, the interest rate environment could become volatile, as could other, riskier assets. This is also a difficult time for the world economy, with sovereign debt problems posing severe threats for Europe that could cascade to the US quickly.

There’s also the likelihood that the stock market remains precarious as analysts aggressively downgrade estimates for the upcoming earnings season.

“We see no catalyst for a market rally in the near term, making the risk more prominent on the downside,” Sonam W. Pokwal, credit strategist at Citigroup, wrote in a note to clients. “With correlation so high, the sensitivity of virtually all trades to Europe and US macro developments is extremely high, and with volatility ensuring pain on an incorrect bet, this game is most definitely high stakes. Staying on the sidelines is where we feel most comfortable.”

As such, Stovall writes that S&P similarly “recommends that investors maintain a neutral exposure to equities overall,” with a preference toward large-cap quality stocks with above average dividends—a safety play despite the strong dividend buy signal.

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